Outsourcing: How to avoid contract disputes

Stephanie Overby |
June 23, 2011

Disputes, of course, can hurt performance, and the compromises required to resolve them can leave both parties unhappy.

Outsourcing relationships are long and complex--the contracts that establish them seemingly more so. Yet for all their verbosity, many outsourcing contracts are filled with generalities and open questions, which can present major problems when conflicts between outsourcer and customer inevitably arise.

"One of the goals of outsourcing contracts is to develop a smooth working relationship between customer and supplier," says Brad Peterson, a partner in the business and technology sourcing practice of Mayer Brown. "When contract language is unclear, the parties develop different interpretations of the contract and those differences lead to disputes."

Disputes, of course, can hurt performance, and the compromises required to resolve them can leave both parties unhappy.

Uncertainty in the contract can also lead to litigation. "Where the potential outcome is reasonably certain to both parties, they usually can reach an agreement on how to settle the matter and avoid a trial or arbitration," says Robert Kriss, a partner and litigator at Mayer Brown. "If the potential outcome of a dispute is uncertain, the parties may evaluate their positions very differently, making it difficult to settle."

Both sides lawyer up--digging through old emails, unearthing draft contracts, and interviewing witnesses--and that racks up billable hours for attorneys on both sides.

Outsourcing customers can mitigate the risk of costly disputes by insisting on clarity at the time the contract is executed and at the first sign of trouble, say Peterson and Kriss. Anticipating all the issues that may arise during an outsourcing relationship is difficult, but drafters of outsourcing agreements should try to address as many specific problems as possible upfront to save money and heartache later.

"You need to prove what promises the parties intended by the agreement, whether those promises were kept, and who is responsible for failures," Peterson says. "The more you think about problems of proof as you are drafting the contract and governing the relationship, the fewer costly factual disputes will arise after the contract is executed."

In other words, think like a litigator at the negotiating table. Here are six tips for buttoning up your outsourcing contract.

1. Provide Specific Examples of Damages

Outsourcing contracts may state that the parties can recover only "direct damages," not "consequential" ones. But case law is unclear about what constitutes direct versus consequential harm, says Peterson. Outsourcing customers should provide specific examples of what they consider direct damages, such as the cost of having the work performed by another provider, and what they consider consequential damages, such as lost profits.

2. Avoid Open-Ended Terms

Many outsourcing contracts state that the parties will attempt to reach agreement on an important provision after signing. That's a mistake, according to Kriss, who advises clients to avoid leaving contract provisions unresolved for two reasons. For one, the parties may not be able to reach an agreement. For another, he says, a court or arbitrator may be reluctant to impose a term without guidance in the contract.

"If such a[n open-ended] provision is unavoidable, consider stating in the contract that the parties agree to an arbitrator or industry expert supplying the missing agreement after hearing the parties' arguments and such decision will be binding and non-appealable," Kriss says.

Alternatively, if the contract does not specify a process for supplying the missing term, it should at least state what happens to the validity of the rest of the contract if no agreement is reached.

3. Provide Specific Examples of Material Breach of Contract

An outsourcing contract often states that the relationship can be terminated for "material breach." But as with damages, case law is unclear about the definition of material breach, especially in a particular case, says Peterson.

Lay out examples of material breach in the contract--such as failure to meet a specified number of service levels or intellectual property theft--to clarify termination rights. Even if a breach does not fall within the examples, they can still be useful in assessing whether the breach in question is material, says Peterson.

"If the breach in question has the same or greater adverse monetary impact on the customer's business as one of the breaches listed as an example, then the breach in question is probably material," he adds.

4. Define Performance Standards

Many outsourcing contracts require conformity to "industry standards" or performance that is "appropriate," "sufficient" or "best practice." The problem with these adjectives, says Kriss, is that they have no clear meaning.

Instead, define specific standards of performance: tasks the provider is required to perform or results the provider is expected to achieve.

5. Require Written Notice of Customer Failure

When outsourcing disagreements arise, the supplier may blame the customer. Therefore, the contract should require the supplier to provide contemporaneous written notice to a specified officer of the customer when the supplier contends that the customer is failing to meet its obligations. That will go a long way toward "avoid[ing] costly litigation over retrospective, unfounded excuses and [will] provide the customer with an opportunity to avoid the dispute altogether," says Peterson.

"Such a provision makes it much easier to identify the cause of the problem before it develops or as it is developing," he adds. "Otherwise, the parties may have to determine causation long after the fact by reviewing hundreds of e-mails, interviewing witnesses and hiring experts."

If the customer really is at fault, the provision will help to alert IT leaders of the internal issue that needs to be corrected.

6. Provide Written Notice of Any Breach of Contract

Outsourcing customers can limit the cost of disputes and litigation even after the ink is dry. "The biggest mistake we see in dispute resolution is failing to send firm correspondence about breaches," Kriss says. "Yes, it's time consuming and won't be popular with the supplier. However, if you don't send that correspondence when the problem is developing, it will be more difficult afterwards to sort out which party was responsible for the problem."

For example, if a customer adds personnel to mitigate damages caused by the supplier's failure to perform but fails to provide clear written notice to the supplier before the personnel are added, it will be more difficult for the customer to prove that the personnel were added in response to the supplier's failure to perform.